AIG Sues Federal Reserve; Are Goldman, Citi, BofA Its Real Targets?

American International Group (NYSE:AIG) filed a lawsuit against Maiden Lane II, a vehicle created by the Federal Reserve of New York to facilitate a bailout of the insurer. Maiden Lane II was created in December 2008 and funded by the Federal Reserve to purchase residential mortgage-backed securities ("RMBS") from AIG to ease liquidity strains caused by losses in its securities lending unit. AIG's end goal is to reserve its right to seek damages from Bank of America (NYSE:BAC) and other issuers of the soured RMBS. According to Reuters:

The complaint filed in the New York State Supreme Court in Manhattan seeks a declaration that AIG has not transferred billions of dollars of "litigation claims" to Maiden Lane II, including many related to the insurer's $10 billion (6.2 billion pounds) lawsuit against Bank of America ... AIG is not seeking monetary payments in the lawsuit, but wants the court to clarify that the New York-based insurer still has the right to sue issuers of securities in Maiden Lane II.

AIG Liquidity Strain

In the second half of 2008, AIG experienced liquidity strain from capital calls pursuant to both its securities lending business, and credit default swaps it had underwritten. According to SHOCK EXCHANGE's book, "How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead":

The securities lending unit took cash collateral from borrowers in exchange for loans of securities owned by AIG insurance subsidiaries. AIG then invested the collateral primarily in residential mortgage-backed securities ("RMBS") and collected a net interest spread. When customers demanded a return of their collateral backing $69 billion of loans outstanding, AIG had to liquidate the RMBS; however, AIG did not want to sell the RMBS securities at steep discounts and reached out to the U.S. government for help.

Critics later claimed that Maiden Lane II used billions in bailout money to buy the toxic assets and used AIG as a vehicle to pay counterparty claims at 100% on the dollar. Such AIG counterparties included Goldman Sachs (NYSE:GS), Bank of America, and Citigroup (NYSE:C), some of which had already been recipient of funds via the Troubled Asset Relief Program (TARP).

Federal Reserve Position

In August 2011 AIG sued Bank of America, attempting to recover approximately $10 billion in losses on soured mortgage investments; Bank of America's stock plunged 20 percent in one day on news of the lawsuit. The mortgages were underwritten by Bank of America units, Merrill Lynch and Countrywide Financial. AIG claimed that fraudulent loan underwriting in $28 billion of bonds it had purchased from those units caused massive losses. More than $7 billion in losses were related to mortgages acquired by Maiden Lane II. However, the Federal Reserve argued that when AIG sold the distressed securities to Maiden Lane II, it also forfeited its right to seek damages for losses it suffered on the securities.

Conclusion

Last week AIG contemplated suing the U.S. government for having extracted too onerous terms in its 2008-2009 bailout of the insurer. CEO Robert Benmosche said all the right things publicly, noting how important is was to close the door on the past and look towards the future. After receiving billions in bailout funds from the government, both AIG and Bank of America had become nationalized. When one "too big to fail" entity sues another, in effect, isn't the government ultimately on the hook for any potential legal settlement? That's a roundabout way of saying AIG is putting taxpayers at risk for billions in additional capital commitments, and exposing AIG to additional public disdain. The potential public relations nightmare comes at an inopportune time as AIG attempts to prove it can earn consistent profits standalone. According to AIG: Biting The Hand That Feeds It?, the company's operating results have deteriorated since its bailout:

From 2007 to 2011 revenue declined from $81.5 billion to $64.2 billion. Income from continuing operations before taxes also declined from $4.7 billion to a $1.1 billion loss over that same period. In 2010 it recorded a non-recurring gain of $16.3 billion on its divestiture of its Asian life insurance company, AIA Group Limited. While the sale proceeds went to repay government debt, the transaction chipped away at AIG's crown jewel - its Asian insurance franchise.

I recommend that investors analyze AIG based on investment fundamentals, and not the likelihood of a successful lawsuit against Maiden Lane II, and ultimately, issuers of the soured RMBS. That said, I recommend avoiding AIG until it proves it can deliver consistent profits as a standalone entity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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